1. Introduction to Exchange Rates
Today, in the globalized world, the exchange rate plays an extremely important role and countries must carefully choose the most appropriate regime for them. There is a lot of debate about regimes and their characteristics, but all economists agree that there is no adequate trading system for all countries in the world and that before deciding to adopt a or another, countries should affect Moreover, since the 1970s, the diversity of exchange rate regimes has widened. All of these reasons make the selection of the exchange process more complicated than ever.
In the first section of this paper will be defined and overviewed different exchange rate regimes, their advantages and disadvantages. In the second part will be identified the factors which influence country’s exchange rate regime choice. The last part of the paper reviews the selection of exchange rate regime tendency over developing and underdeveloped countries and developed countries.
2. Exchange rate Regimes
a. Definitions
In the published literature are separated three general regimes of exchange rate: fixed, floating and intermediate. Fixed exchange rate regime is a system where a country fixes its national currency’s rate against another foreign currency or currency basket (Caramazza, et al., 1998). Its general purpose is to stabilize a country’s currency and to avoid huge, unpredictable fluctuations (Rodriguez, 2009) On the other hand, in flexible exchange rate regime external currency’s value is regulated by its supply and demand in the market and allows country’s central bank to focus on other macroeconomic objectives (Caramazza, et al., 1998) Intermediate exchange rate regime defines all regimes which are neither entirely fixed, nor absolutely floating. examples for each general exchange rate regime from International Monetary Fund classification and defines each IMF exchange rate category.
b. Classification of Exchange rate regimes
According to IMF exchange rate classification system are divided in to 3 General Regimes i.e. Fixed exchange rate regimes (Hard pegs), Intermediate exchange rate regimes (Soft pegs) and Flexible exchange rate regimes (Floating) (IMF Annual Report, 2016).
1. Fixed exchange rate regimes: Also known as Hard pegs. It can be classified by requiring either the legally mandated use of another country's currency that’s is a country uses foreign currency as the national currency example Andorra, Kosovo, Monaco, Montenegro, San Marino, Vatican City uses Euro or a legal obligation that forces the central bank to exchange its local currency for a particular foreign currency at a fixed amount. It requires 100% foreign currency reserves also known as currency board for example Bulgarian lev against Euro (Mark Stone, 2008).
2. Intermediate exchange rate regimes: Also known as Soft pegs, in this type of system a currency is pegged (anchor) to another currency or a combination of currencies and this currency is allowed to fluctuate around either a narrow-fixed rate of ±1% or a wide fixed rate of ±30% (depends on inflation rates of the particular country) for example Hungary was peg to Euro until February 2008. And currently China is an example of this type of peg (Mark Stone, 2008).
3. Flexible exchange rate regimes: Also known as Floating peg, which can be further sub classified in to Managed floating and Free floating. As the name implies that the exchange rates are market driven. But Central banks can intervene in floating exchange rate by purchases or sales of foreign currency in exchange for local currency. However, they do not have any previously announced specific target rates this is known as Managed floating for example India manages its floating peg. Whereas Free float is completely regulated by the market for example, Iceland, New Zealand, Sweden, the US, and the Euro area the central banks mostly certainly not intervene to manage the exchange rates (Mark Stone, 2008).
c. De Facto vs. De Jure Exchange Rate Regimes
It is also relevant to define exchange rate regimes as de jure or de facto. If simply defined De jure exchange rate regime is the officially stated country’s regime and de facto is the regime which country actually follows. It is important to separate both of them because in a lot of cases countries do not truly follow their stated regimes and de jure regime could be misleading. In order to compare de jure with de facto exchange rate there were established several de facto classifications which use data of observed performance of exchange rate and it influences variables, for example, variation in national reserves (Michael D., 2003). All of them declare that there is a significant difference between country’s official exchange rate and de facto rate (Andrew K., 2011). To explain those differences authors in the modern literature widely use terms “Fear of floating” and “Fear of pegging”. Some countries, especially those, which have strong institutions, officially announce floating exchange rate, but in reality, express “Fear of floating” that is reluctance to adjust exchange rates in emerging markets and strongly intervene in the market in order to stabilize their exchange rate performance, because, for instance, strong devaluation of a currency usually is taken by the market as a sign of instability. However, those countries do not officially announce fixed exchange rate, because they try to avoid overtaking its disadvantages and the official floating rate provides country with flexibility which in upper economic cycle allows it to use benefits of float. On the other hand, the countries, that usually have weak economic institutions, express “Fear of pegging” and even though they officially fix their exchange rate, unofficially they have floating rate, because their institutions are not qualified enough to maintain the peg and signal (Alesina, et al., 2006).
Nevertheless, even though there is quite a big difference between de jure and de facto regimes, we still cannot concentrate just on de facto one because there is no common classification of it and all established classifications have huge differences between each other starting with the used time frequencies and finishing with the number of categories in classification model (Andrew K., 2011). Also, de jure regime signals official government position and intentions which, accordingly, drives market expectations. Moreover, (Guisinger, et al., 2010) argue that countries have stronger benefits from fixed or flexible regimes when their official announcements and actual actions match (Guisinger, et al., 2010).
d. Advantages and Disadvantages
1) Fixed Exchange Rate Regime
One of the benefits of fixed exchange rate regime is its association with stability, sound fiscal and structural policies and low inflation. Fixed exchange rates reduce exchange rate risk; therefore, investors can hold their assets in the foreign currency without fear that their value will drop and the necessity to predict future exchange rate is eliminated (Murray, 1999). Consequently, by pegging its currency and lowering exchange rate risk, a country could decrease its transaction costs and increase its international trade amounts or, from the other point of view, if the country already trades a lot with another specific country, it is reasonable to peg its currency and eliminate the exchange rate risk (Andrew K., 2011). Moreover, if a country chooses to peg its currency to a low inflation currency it could help to cope with too large domestic inflation. However, it is important to notice, that a country could import not only lower inflation perspectives, but also economic problems from another country, so it is extremely important to choose carefully the currency to peg (Obstfeld, et al., 1995).
Another positive aspect linked to fixed exchange rate is the credibility. If the countries institutions are not capable of resolving monetary problems, but are qualified enough to maintain the peg, it could gain more credibility with by fixing exchange rate (Alesina, et al., 2006). Furthermore, as long as the peg is credible, expectations for high inflation are usually kept low (Caramazza, et al., 1998). Nevertheless, only fixed exchange rate does not bring credibility to the country and without qualified economic institutions it is not able to assure reliability (Rodriguez, 2009)
The most in literature quoted arguments against fixed exchange rate regime are the abandonment of independent monetary policy and inability to offset external economic shocks. Both are highly connected. By adopting fixed exchange rate a country’s policy-makers must focus on maintaining it and central bank loses its other functions such as lender of last resort and neutralizing external macroeconomic shocks, meaning that this duty must be overtaken by the local government (Caramazza, et al., 1998)Murray also stresses that if country experience regularly macroeconomic changes and exchange rate cannot adapt in order to cancel them out, then suffers its employment rate and output. However, the monetary policy independence loses its importance if the partner country experience similar macroeconomic shocks, has the same monetary policy aims and is strongly capable of reaching them. Moreover, once again, it is seen even as a positive factor in countries where central bank is not able to reach monetary objectives itself (Murray, 1999).
Another reason opposing fixed exchange rate is difficulty to maintain it. It is especially suitable for countries with much higher domestic inflation rate. An attempt to keep too high nominal value of the pegged currency could lead to higher tension in economy, panic, speculative attacks and eventually to exhaustion of foreign currency reserves as well as abandonment of the peg. Additionally, if central bank is committed to preserve the peg, the devaluation of the currency and especially the collapse of the system are extremely expensive for the local government (Obstfeld, et al., 1995).
2) Flexible Exchange Rate Regime
The first important benefit of flexible exchange rate is country’s independent monetary policy, which can target relevant macroeconomic issues like inflation or unemployment rate and allows country to avoid importing economic problems from other countries (Rodriguez, 2009). Regarding this point, it is important to stress the significance of reliable and independent central bank which is capable of credible managing country’s monetary policy, because flexible exchange rate could create an incentive for authorities to boost the inflation rates (Caramazza, et al., 1998).
Another positive aspect of flexible exchange rate is its stabilizing effect against external shocks. When country experience sudden macroeconomic change, flexible exchange rate moves in the appropriate direction and offsets some negative effects of the shock without any (or very little) impact on the other macroeconomic indicators like employment rate or output (Murray, 1999). Furthermore, according to Cruz, the flexible exchange rate provides a country’s government with lower political costs of rate adjustments compared with the fixed exchange rate (Rodriguez, 2009)
The major disadvantage of floating exchange rate is the exchange rate risk and its volatility. It could result in lower trade and reduced foreign investment, because of the investor’s uncertainty and fear for decline of assets future value due to the negative change of exchange rate (Obstfeld, et al., 1995)
3) Intermediate Exchange Rate Regime
The intermediate exchange rate tries to capture advantages of both flexible and fixed exchange rate and balance between reliability and flexibility. Nevertheless, if it is very clear what government is going to do in order to manage its exchange rate (for example devaluate currency in case of crawling peg regime), it exposes a currency to speculative attacks and, if it is absolutely not clear about governments actions regarding exchange rate, then it can result in lower foreign investment, because of investors uncertainty about the future conditions.
3. Factors determining – Which exchange rate to choose?
Figure 1 Factors Determining Which Exchange Rate Regime to choose? Source: Author
1) External debt
Another relevant determinant in choosing exchange rate regime is external debt, because exchange rate fluctuations affect it directly: when the exchange rate increases (direct quote), “The size of liabilities denominated in foreign currency also rises, affecting the competitiveness of a country. Due to this reason countries, which have high foreign debt, should consider fixing its exchange rate to the currency or the basket of currencies in which the debt is denominated” (Alesina, et al., 2006). The one negative aspect of it could be that the fixed exchange rate could build the government’s temptation to let inflation to rise in order to pay back its debt more (Poirson, 2001).
2) International Trade
International trade play also an important role in choosing exchange rate regime. Countries trading a lot with one or several partners, who have a particular currency, could adopt fixed exchange rate and increase their trade benefits provided by a peg (Caramazza, et al., 1998). In fact, it is known that some countries, that actually adopted the peg, increased their trade with the partner country. This is especially true with the small sized and open economy countries. Additionally, for too small countries sometimes it is cheaper and highly recommendable to fix exchange rate or even to adopt foreign currency in order to avoid too high exchange rate fluctuations. On all the other cases a country’s size does not play a significant role (Andrew K., 2011).
3) Inflation
There are known a lot of successful cases where fixing exchange rate helped countries overcome inflationary problems (f. e. East and Central Europe between 1994-2004), therefore countries, which are struggling with higher than desired inflation rates and having quite weak institutions, which are not able to control them, could consider adopting fixed exchange rate regime (Ghosh, 2003). However, (Edwards, 1996) argues that countries which had a long time high inflation will have more difficulties in maintaining the hardly fixed exchange rate.
4) International reserves
Study done by (Edwards, 1996) provides enough evidence that before adopting a peg, a country should build high international reserves in order to handle speculative attacks. If, however, it does not have enough reserves, it should consider adopting the flexible exchange rate, because in freely floating regime there is no need to use them.
5) Credibility
For countries with high inflation it is advisable to adopt intermediate regime, like crawling peg, which could help little by bringing inflation down without resulting in the collapse of exchange rate regime. One way or another, by the commitment to peg the currency, country’s government shows its determination to monetary stability, therefore a peg could result in higher credibility of country’s central bank and its dedication to fight inflation (Alesina, et al., 2006).
6) Type of shocks
It was stated in (Rodriguez, 2009) that one of the most essential factors playing role in choosing exchange rate regime should be the type of shocks which country is experiencing with higher frequency and the openness for capital mobility. If a country is open and dependent on foreign capital as well as its shocks are real and/or coming from abroad, flexible exchange rate would serve as an economy stabilizer in the problematic times. However, if country experience more monetary disturbances than real shocks, then the fixed exchange rate should offset it better than the flexible one (Rodriguez, 2009).
7) Political factors
Lastly the political factors also influence exchange rate regime choice, even though they should not. In unstable political environment, the government usually has incentive to let exchange rate fluctuate because, the depreciation of domestic currency under the flexible regime is less noticeable to the public and it is less politically expensive than to take unfavorable decisions and do necessary devaluations under fixed exchange rate. (Poirson, 2001).
8) Capital mobility
(Caramazza, et al., 1998) states a very important point that countries exposed to high capital inflows should consider adopting the flexible exchange rate because under fixed exchange rate, increase in capital inflows could lead to real domestic currency depreciation due to the rise of domestic inflation, and the burden to maintain a peg could become unbearable (Caramazza, et al., 1998).
To sum up, we can notice that exposure to external shocks, high capital mobility, low foreign reserves and political instability could affect the choice of flexible exchange rates. It is important to mention, that countries with developed financial institutions also would tend to keep monetary policy flexible and adopt floating exchange rate (Edwards, 1996). On the contrary, large external debt, frequent international trade, small size of the country, higher inflation and the aspiration for credibility could influence acceptance of the fixed exchange rate regime.
4. Exchange Rate Regimes
It is quite complicated to identify the world’s trend of exchange rate regime choice. Many sources state that over the previous decades more and more countries were moving towards flexible exchange rate (Michael D., 2003). And indeed, according to latest IMF report, 37% of IMF members have floating exchange rate and only 13% hard pegs (IMF Annual Report, 2016). Nevertheless, one could argue about the countries which belong to Eurozone: from the external and widely recognized point of view, euro is freely floating currency, however from the internal view, countries gave up their own currencies and monetary policy in order to adopt one common currency released by European Central Bank, and therefore from their perspective it could be interpreted as a form of hard peg (Poirson, 2001).Moreover, it was stated in (Andrew K., 2011) that, for at least half of the world’s currencies national central banks intervene in the market in order to reduce exchange rate fluctuations (Andrew K., 2011). One way or another, all literature agrees that even though lately shifts in exchange rate regimes became infrequent, usually countries do not keep everlasting peg and tend to switch to more flexible regimes (Andrew K., 2011)
Further in this paper the countries are divided in developed, emerging and developing countries, in order to better identify their preferences for exchange rate regime.
a. Undeveloped Countries and Developing Countries
The biggest emerging countries, like Mexico, Brazil, India and others, have a tendency to adopt floating exchange rate. The major exception is China which still pegs its currency at a relatively cheap rate in order to make its exports more attractive to the world market (Andrew K., 2011).
For the developing countries the trend is not so clear. Even though majority sources identify that since early 1990s they tend to move from intermediate towards flexible exchange rate (Rodriguez, 2009), if we exclude main emerging economies, then the number of floaters among developing countries reduces significantly. Also if we consider soft pegs, in IMF de facto exchange rate report, as intermediate regime, than 72 developing countries still use this form as their exchange rate regime (IMF Annual Report, 2016) (Andrew K., 2011) claims, that the smallest countries in the world are adopting foreign exchange rate or currency board agreements. This statement is supported by IMF 2016 report and is also true for politically troubled countries, where people lost their confidence in their own monetary system, like Ecuador. According to (Andrew K., 2011), also the former French colonies have a trend to maintain soft form of peg to euro, what was still valid in 2016 (IMF Annual Report, 2016). In general, the developing countries, which maintain a hard or soft fixed exchange rate usually peg to US dollar, euro or their neighbor countries’ currencies (Andrew K., 2011). On the other side, as were already mentioned, a lot of economist state, that by creating adequate and credible institutions, the developing countries can achieve inflationary aims without abandoning the flexible exchange rate policy. Some countries, for instance Peru, Colombia or Israel, are implementing this idea: they go for flexible exchange rate and improve the quality of their financial institutions, which target inflation rates (Michael D., 2003).
b. Developed Countries
Since the collapse of Breton Woods agreement most of the developed countries have flexible exchange rate. This is true not only for major currencies like US dollar, euro or Japanese yen, but also for British pound, Swiss franc, Australian and Canadian dollars and other quite rich economies. Their tendency to float is a result of high financial development and advanced financial institutions, which are able to maintain stable economy without necessity to peg their currency (Michael D., 2003). According to IMF 2016 report most of them have inflation as their main monetary policy target, but there are some economies like USA which are overseeing several macroeconomic indicators (IMF Annual Report, 2016)
5. Conclusion
The process of choosing the exchange rate regime is extremely difficult and there is no one type of exchange rate suitable for every country in the world. Countries have to consider three general types of exchange rate – fixed, flexible and intermediate – their benefits and limitations, its economic targets and macroeconomic environment. The advantages of the fixed exchange rate, such as lower inflation expectations, higher credibility, reduced exchange rate risk and transaction costs as well as increased trade, could be suitable for a country, which wants to reduce its inflation, has larger external debt and seeks more credibility. However, with the fixed rate a country must leave its own independent monetary policy, and with that, the ability to cope with external economic disturbances. Moreover, it is exposed to speculative attacks and the risk to import other economic problems from the partner country. All those disadvantages disappear with the flexible exchange rate. Nevertheless, flexibility has its own limitations and the largest of it is the unpredictable exchange rate volatility, which could result in lower trades and investment.
In general, it is possible to observe that developed countries have flexible exchange rate and their advanced financial institutions are coping with inflation or other macroeconomic targets. Majority of main emerging markets also are inclining to adopt flexible exchange rate regime. However, the trend is quite unclear among developing countries. Some of them try to follow developed countries example, adopt flexible exchange rate and establish strong central banks targeting important economic indicators. Others try to cope with inflation by pegging their currency to one of major or developed neighbor country’s currencies as well as replacing their own weak with strong foreign currency.